A flight from short-term paper

Stock markets calmed in the early part of last week -- but the real indicator of whether the turmoil is easing is the money market. Developments in the US treasury yield curve will bear close scrutiny this week before key investment decisions are made.

The leading indicator of market volatility, the Chicago-based VIX index, fell sharply after the Federal Reserve Bank announced a cut in its discount rate on Friday August 17. It continued a steady decline in the week that followed. The Standard & Poors' 500 and other leading stock market indices have all climbed since the cut, albeit with continuing volatility.

But the real action in the current turmoil has been in the money markets. Many financial institutions rely for their day-to-day financing on rolling over short-term commercial paper, often using as collateral assets such as the mortgage-backed securities that are at the centre of market fears. This market has seen a dramatic fall in willingness to supply finance, leaving a question mark over the short-term viability of some leading financial institutions. Central bank interventions to provide liquidity, including the Fed discount rate cut, have been aimed at overcoming the associated difficulties.

Long-term bond yields have remained relatively flat, coming in slightly on higher demand, reflecting investor uncertainty generally and concerns about prospects for longer-term US growth. The yields on short-term US government debt however have been highly volatile, sinking below 2% in intra-day trading. This reflects investors' dash for safety as they abandoned short-term commercial paper in favour of Treasuries.

What the figure shows clearly is that the Fed intervention did nothing to reverse the fall in yields, merely decelerating it slightly before the more rapid rate resumed on the next business day. On Tuesday 21 August however, these short-term yields rebounded sharply. This was in response to two main drivers:

Chair of the Senate banking committee Christopher Dodd made a reassuring public statement after meeting with Fed Chairman Ben Bernanke, stating that he had asked if Bernanke would use 'all his tools' to contain the turmoil and had received a positive response. Markets interpreted this as implying that the Fed would cut the main policy rate before the next scheduled FOMC meeting in September, although Fed spokesmen denied any change from their Friday 17 statement of vigilance.

A greater volume of short-term debt was made available for sale by the Fed, which then struggled to find buyers -- resulting in higher yields than on the debt trading in the marketplace.

This week, the money market will show clearly whether investors have indeed been reassured about the likelihood of the market turmoil being contained -- or if the respite has been merely temporary.